Introduction to Purchase Price Accounting (PPA)

Purchase Price Accounting (PPA) is one of the many topics requiring specific accounting under the Generally Accepted Accounting Principles for the United States (US GAAP), and is related to activity for mergers and acquisitions (M&A). It involves allocating the purchase price paid in an acquisition to the acquired assets and liabilities from a new business.  

PPA ensures the financial statements accurately reflect the fair value of the acquired company's assets and liabilities, essential for investors and stakeholders to understand the transaction's financial impact.  

The goal of this article is to provide an overview of the framework and various considerations for Purchase Price Accounting under US GAAP. 

US GAAP Framework 

Under US GAAP, the primary guidance for PPA is found in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 805, Business Combinations. It is mostly commonly referred to as “ASC 805.” 

ASC 805 provides guidance on accounting for business combinations, including the identification and valuation of acquired assets and liabilities, the recognition of goodwill or a bargain purchase gain, and the treatment of transaction costs. 

There is a specific Subtopic within ASC 805, noted as ASC 805-50, which outlines the accounting treatment for purchases/acquisitions of certain assets, rather than an entire entity. These are commonly referred to as “asset acquisitions.” While much of the accounting for asset acquisitions is similar to business combinations, there are certain key differences, such as the lack of recognizing goodwill and the treatment of transaction costs. 

Determining the Type of Transaction 

What Qualifies as a Business Combination? 

A business combination occurs when there is a transaction that results in a “change of control” over a business, typically through mergers or acquisitions. Control is considered as having a majority (over 50%) of decision-making ability over the business. Examples include: 

• Acquisitions and Mergers: Generally considered a business combination when 51%+ of ownership (stock, LLC units, etc.) is obtained by an owner/investor. 

• New Minority Investor: Not generally considered a business combination, as the minority investor is not receiving 51%+ of ownership. Therefore, a change in control has not occurred. 

• Structured Asset Purchases: Even if legally structured as an asset acquisition, an asset purchase should be reviewed to determine if the acquired assets meet the definition of a business. 

What is Considered a Business? 

To fall under the scope of Purchase Price Accounting, the acquired entity (or assets) need to meet the definition of a business. According to ASC 805, a business consists of inputs and processes that, when applied together, have the ability to create outputs. 

For acquisitions of a fully operational company, this may be relatively straightforward. However, in other scenarios, such as an asset purchase, or acquiring a legal entity that only contains 1-2 key assets, further evaluation may be required. 

There are 2 key considerations for meeting the definition of a business: 

1. It must be evaluated whether a “screen test” is met, to see if “substantially all” (i.e., 90%+) of the total assets acquired are concentrated in a single asset or group of similar assets.  

   • For example, if you acquire a legal entity that primarily consists of a key software platform or proprietary intellectual property, with minimal other assets, this transaction is classified as an asset acquisition rather than a business acquisition. 

2. It must be evaluated if the acquisition includes both “inputs” (e.g., employees, equipment, materials) and “processes” (e.g., formulas, operational manuals) that together can result in the creation of outputs (e.g., finished goods, services). 

As an example, let’s assume that a company has purchased a manufacturing plant.  That manufacturing plant has the following: 

By using the included inputs and processes above, the company could create outputs, in the form of finished goods that are ready for sale. 

This acquisition likely constitutes a business as it includes inputs, substantive processes, and the ability to create outputs. 

Importance of Correct Classification 

Correct classification is critical because it has significant implications for financial reporting. Misclassification can lead to incorrect financial statements, affecting stakeholders' understanding and decision-making.  Accurate classification ensures compliance with accounting standards, provides clarity for stakeholders, and supports reliable financial reporting. 

Accounting for Business Combinations 

Identifying the Acquirer 

Once the transaction is determined to be a business combination, it must be determined who is considered the acquirer. 

Most commonly, this step is straightforward, and the acquirer is the party paying cash, equity, etc. for the acquired business. 

However, there are scenarios where this can be far more complex. For instance, if 2 similar-sized businesses are undergoing a merger, then it may be difficult to determine which of the businesses will be considered as the “accounting acquirer.” This is a common challenge when evaluating special purpose acquisition companies (SPACs) and the companies they are acquiring.  

Identifying the Acquisition Date 

Another straightforward step is in identifying the acquisition date, or the date at which control of the business is obtained by the acquirer. This is often considered as the date of the purchase agreement. However, agreements may state a different closing date, or specify certain conditions that may take more time to be met before the acquisition is considered closed. 

Purchase Price Consideration 

After the above steps, we now reach the core concepts of Purchase Price Accounting.  

First, it is important to evaluate everything provided to the sellers in return for the acquired business, what is referred to as the “purchase price consideration.” This can include current and future cash payments, equity instruments issued, or other assets.  

Examples of purchase price consideration are: 

It may also include possible future payments based on whether certain post-acquisition events occur or not. One common instance of this is “earn-outs,” where a seller will only receive a certain payment if they meet certain revenue or EBITDA targets for a future period. These contingent payments are referred to as “contingent consideration.”  

All purchase price consideration is measured at its fair value on the date of acquisition. This is simple for cash, as well as for loans/notes to sellers at market rates. However, items such as equity and contingent consideration can be difficult to value and may require involvement of a valuation specialist. 

Consider a scenario where Company A acquires Company B. The purchase price consideration might include: 

• $10 million in cash payments 

• 1 million shares of Company A's stock valued at $50 per share 

• An agreement to pay an additional $2 million if Company B achieves certain revenue targets within the next two years 
  
  

The fair value of the purchase price consideration on the acquisition date would be calculated as follows: 

• Cash Payments: $10 million 

• Equity Instruments Issued: 1 million shares x $50 per share = $50 million 

• Contingent Consideration: With the help of a valuation specialist, and when considering multiple future scenarios, the fair value of the possible additional $2 million is estimated at $1.5 million on the acquisition date.  

Total Purchase Price Consideration: $10 million + $50 million + $1.5 million = $61.5 million 

Identifiable Assets and Liabilities 

After you determine purchase price consideration, you then need to identify all the assets and liabilities that it will be allocated to. 

The best starting point for this exercise is in obtaining a Balance Sheet (or trial balance) of the acquired company as of its acquisition date; this is commonly referred to as the “Closing Balance Sheet.” Ideally, this is a report that can be easily pulled from your accounting system. However, if the acquisition date is not at the end of a given month, and if your accounting system does not provide reporting as of a mid-month date, then additional work may be needed to adjust accounting activity to reflect the correct date. 

It is critical to understand the terms and conditions of the acquisition, including any discussions of whether all assets/liabilities of the business will be acquired, or if some will be excluded from the transaction. 

Some existing assets may be required to be written off, which could be due to being replaced by new assets, or having no future benefits to the company as of the acquisition date. Common examples include balances for intangible assets prior to the acquisition and any capitalized incremental costs to obtain a revenue contract (e.g., sales commissions). 

However, it is also common to identify new intangible assets or liabilities not previously recognized on the pre-acquisition balance sheet. Common examples of these newly identified intangible assets include: 

• Existing Customer Contracts/Relationships  

• Trademarks 

• Marketing-Related Assets 

• Developed Software/Technology 

• Non-Compete Agreements  

• and more  

A valuation specialist is generally needed to help identify applicable assets and determine their fair value as of the acquisition date. 

Fair Value Measurement 

For each identified asset and liability, the next step is to determine its respective fair value as of the acquisition date. 

For most short-term assets and liabilities on an acquired company’s balance sheet, the exercise can be straightforward. Many of these can be considered to have their recorded amounts reflect fair value. 

However, for more significant long-term balances, such as new intangible assets or long-term debt, further evaluation may be needed to determine if adjustment is required to reflect its fair value. 

Goodwill and Purchase Price Allocation 

With all of the above information, the final step is to allocate the total purchase price consideration over all the identifiable assets and liabilities based on their acquisition-date fair value. 

For most business combinations, after the allocation over all identifiable assets and liabilities, there is a remaining amount of the purchase price consideration. This excess amount is recorded as a Goodwill asset to complete the Purchase Price Allocation. 

In very rare cases, the amount of purchase price consideration will be less than the total amount of identifiable assets and liabilities. This assumes that the buyer has purchased the acquired company at a discount, and the difference is recorded as a Bargain Purchase Gain in the acquirer’s Income Statement/P&L as of the acquisition date. While there may be some cases where this is correct, the existence of a Bargain Purchase Gain is considered a red flag for auditors/reviewers, and guidance suggests revisiting the fair value measurement of the acquired company’s identifiable assets and liabilities to ensure they are correct. 

Transaction Costs 

In addition to the amounts paid to the seller, the acquirer may incur various costs to third-parties related to the business combination, referred to as “Transaction Costs.” This may include legal fees paid to the acquirer’s legal counsel, diligence fees paid to review the acquired company, escrow fees, or other administrative costs. 

An acquirer’s transaction costs are not considered as part of the purchase price consideration, and are instead expensed as those costs are incurred.  

Additional SEC Reporting Considerations 

While the previous sections are applicable to business combinations for all companies, there are additional disclosure requirements for publicly traded companies and their business combinations. This can include disclosure of the acquired company’s prior period financial statements for multiple fiscal years, as well as pro-forma adjustments. 

A separate analysis of 3 “significance tests” are required for a public company’s acquisitions to determine the level of additional disclosure: 

• Investment Test: Comparing the acquirer’s total investment amount in the acquired company, as a % of the acquirer’s consolidated market capitalization. 

• Asset Test: Comparing the acquired company’s total assets as a % of the acquirer’s consolidated total assets. 

• Income Test: Conducted through 2 metrics: 

  • Comparing the acquired company’s operating income/loss to the acquirer’s consolidated operating income/loss.

  • Comparing the acquired company’s revenue to the acquirer’s consolidated revenue. 
    

The results of these 3 significance tests are evaluated against certain % thresholds. If the acquired company makes up less than 20% for each of the tests, then most additional disclosure requirements are not needed. If greater than 20% for any of the tests, then one (or more) fiscal years of audited financial statements for the acquired company may be required, as well as unaudited interim information. 

Further details on these significant tests can be found on the SEC’s website. 

Accounting for Asset Acquisitions 

Some transactions may be evaluated to not meet the definition of a business: 

• This could be through the “screen test” performed, if 90%+ of the fair value of gross assets acquired are concentrated in a single asset, or group of similar assets. An example of this may be a company that purchases the assets of a software platform from another company. 

• This could also occur if the acquirer does not purchase both a) inputs and b) processes that can be used to create outputs. 

Using a similar example to the manufacturing plant above, if Company A purchased only the physical assets and the intellectual property of Company B, but did not purchase the operational processes, then what was acquired through the transaction is not enough to create the intended outputs, and the acquired assets do not meet the definition of a business. In this case, the manufacturing plant would be accounted for as an asset acquisition. 

Most of the accounting for an asset acquisition is very similar to a business combination. For instance, you are still required to determine the purchase price consideration, as well as all identifiable assets and liabilities being acquired, and determine their acquisition date fair value. 

However, there are 2 key differences between accounting for a business combination and an asset acquisition. 

No Goodwill 

For an asset acquisition, the purchase price consideration is allocated over the acquired assets based on their relative fair values (as a % of total fair value of all assets), and not their actual fair values. Because of this, there will be no excess amount to allocate after the Purchase Price Allocation.  

As a result, goodwill is not recognized in asset acquisitions. 

Transaction Costs 

In asset acquisitions, transaction costs are considered part of purchase price consideration. They are therefore capitalized and included in the purchase price allocation. This is a different treatment from business combinations, where any transaction costs are expensed as they are incurred. 

In the manufacturing example, if you paid $1,000,000 for the physical assets and $500,000 for the intellectual property, and incurred $100,000 in transaction costs, you would allocate the transaction costs to each asset based on their relative fair values. 

Challenges and Complexities in PPA under US GAAP 

Complex Valuations 

Valuing intangible assets, such as customer relationships and proprietary technology, can be challenging due to the need for specialized knowledge and assumptions about future economic benefits.  

This is also the case for certain components of purchase price consideration, such as valuing any equity interests issued, loans/notes to the seller (especially convertible notes), and contingent consideration like earnouts. 

These valuations often require the use of complex models and significant judgment typically handled by a valuation expert. 

Closing/Opening Balance Sheet 

Establishing accurate balances as of the acquisition date is difficult, especially for complex acquisitions with numerous adjustments and revaluations.  This involves careful assessment of fair values and often includes coordination with multiple departments and external advisors. 

Related Agreements 

Agreements such as lease agreements, transition service agreements, and employment agreements can impact purchase price accounting if contracted amounts are not at market value. These agreements must be carefully evaluated to ensure accurate financial reporting. Any off-market terms may require adjustments to the fair value measurements. 

Integration with Existing Systems  

Integrating the acquired business’s financial systems, processes, and controls with those of the acquirer can be challenging. Ensuring consistent and accurate reporting across different systems requires careful planning and execution. 

Non-Controlling Interests 

When less than 100% of an entity is acquired, determining the fair value of non-controlling interests can be complex. This involves assessing the value of minority interests separately from the controlling interest. 

Deferred Taxes 

Recognizing and measuring any deferred tax assets and liabilities that are acquired as part of the PPA process can be challenging. This includes determining the tax bases of acquired assets and assumed liabilities and assessing the realizability of deferred tax assets and can require a tax specialist. 

Best Practices for Effective PPA 

Early Expert Involvement 

Many accounting teams underestimate the level of involvement required by valuation and accounting experts to make sure that all factors are considered for the transaction. They also underestimate the time required by specialists to receive and review the information and perform their analysis. Starting these steps too late in an audit can end in costly fees for a tight turnaround, as well as back-and-forth with the auditors.  

Engaging these experts soon after the acquisition, and well before the beginning of an audit, ensures accurate and compliant financial reporting. 

Key Documents 

The documentation and paperwork that comes with M&A can be overwhelming; dozens of files and hundreds to thousands of pages of agreements. Save yourself considerable time by knowing the key documents and files that will let you tackle your PPA most effectively and efficiently: 

• Purchase Agreement. This should include any accompanying exhibits, disclosures, and schedules. 

• Funds Flow. This is typically a workbook or spreadsheet that provides details of payments made between all parties for the transaction. It is most helpful in evaluating how each payment is treated under PPA; whether as part of the purchase price, transaction costs, or otherwise. 

• Closing Balance Sheet. Obtaining a Closing Balance Sheet can be the bottleneck for multiple parts of a PPA project, including purchase price adjustments, valuation work, and scoping for identifiable assets/liabilities. 

Closing Balance Sheet Scope 

Obtaining a detailed and accurate report of an acquired company’s acquisition-date balance sheet can be one of the largest efforts for a complete PPA project. One of your first steps should be to obtain this and any supporting details or reconciliations. If unavailable, do not underestimate the amount of time it can take to prepare what is needed. 

Conclusion 

PPA is a complex but essential aspect of financial reporting in M&A. Understanding the differences between business combinations and asset acquisitions, accurately valuing acquired assets and liabilities, and ensuring compliance with US GAAP are critical for effective PPA. 

For tailored guidance and support in PPA, consult with professional advisors who specialize in technical accounting and financial reporting. Zeroed-In Consulting offers expertise in navigating the complexities of PPA and ensuring compliance with US GAAP. Reach out to schedule a discovery call with one of our accounting experts here. 

We’re here to help!

Enter your email below for a list of Key Documents needed!